The SEC’s 2005 attempt to regulate hedge funds using the Advisers Act is now the stuff of hedge fund legend. Still smarting from the LTCM debacle over half a decade earlier, the Commission wanted to require hedge funds to register and report regulatory practices to authorities. Until then – and, to the Commission’s chagrin, subsequently – hedge funds relied on an exemption available to advisers with fewer than 15 “clients.” But when the Advisers Act was created, an “adviser” was generally considered to be a provider of bespoke services to individual investors, not to a collective of investors, i.e. a “fund”. So a hedge fund adviser with, say, one hedge fund, was (and is) only considered to have a single client. All it took was one particularly tenacious hedge fund manager, Phil Goldstein, to challenge the SEC in court and vacate the Commission’s rule.
In order to simplify matters, the media generally reported the court’s 2006 decision as a repudiation of the SEC’s legal authority on the matter. While this is technically true, it remains as the elephant in the room to this day that the underlying reason for the SEC’s failure was the amorphous definition of the term “client.” After the rule was tossed out, the question of the hedge fund adviser’s fiduciary duty, i.e. to the fund or its underlying investors, festered. In other words, the courts had effectively kicked the fiduciary can down the road.
Fast forward to last month when the SEC had another kick at the can. But the SEC’s new proposed rule, resulting from directives spelled out in the Dodd-Frank Act, appears to kick the fiduciary can down the road yet again. Learning from its past mistakes, the Commission basically side-stepped the sticky question of fiduciary duty and simply mandated that any adviser with over a certain amount of assets would need to register. The question of whether the adviser owed a fiduciary duty to investors to the fund was largely ignored.
Largely, but not entirely, that is. The SEC did revisit this question when it addressed the ability for foreign advisers to avoid SEC registration. In order to prevent foreign advisers from treating a collection of US persons as one client when they subscribed collectively (such as through a “nominee” bank), it specifically defined the term “investor” (in a fund) as being different than a “client” (of the adviser):
The term “investor” is not currently defined under the Advisers Act or the rules under the Advisers Act [...] We propose to define “investor” in a private fund…as any person who would be included in determining the number of beneficial owners of the outstanding securities of a private fund…
But the SEC affirmed the notion that a fund, not an investor, was a “client” (our emphasis):
Proposed rule 202(a)(30)-1 would also retain other provisions of rule 203(b)(3)-1 that permit an adviser to treat as a single “client” (i) a corporation, general partnership, limited partnership, limited liability company, trust, or other legal organization to which the adviser provides investment advice based on the organization’s investment objectives…
And so the SEC avoided diving into this thorny issue. By essentially kicking the fiduciary can down the road once again, many questions still linger with regard to exactly who a hedge fund adviser owes their fiduciary duty.
Several of these nagging questions are addressed by Anita Krug of the University of Washington School of Law in a comprehensive, yet very readable article in the Villanova Law Review (“Moving Beyond the clamour for ‘hedge fund regulation”: A reconsideration for ‘client’ under the investment advisers Act of 1940“). In Krug’s view, the SEC should stop kicking the can down the road on this issue and pursue an “investor (as) client” policy as opposed to the traditional “fund (as) client” policy:
…the fund-client doctrine was—and remains—problematic for reasons well beyond its allowing a group of advisers to escape SEC regulation [...] Policy based on the investor-client doctrine…would bring large fund managers within the SEC’s regulatory purview, but, as this Article has argued, it would accomplish substantially more than that.
Krug writes that the SEC has flirted with the definition of client on several occasions in the past. On one such occasion in 1977, it came within a breath of actually defining a fund’s investors (the limited partners) as fiduciary “clients” of the adviser (the general partner):
In the original draft of the court’s opinion, the court stated that those general partners were investment advisers “to the limited partners” of the partnerships. Those four words were not included in the final published opinion, however. That the opinion did not commit itself to either interpretation of “client” meant that the question would persist…
In the Small Business Investment Act of 1980, Krug continues, Congress specifically said that investors in VC funds (a.k.a. “business development companies”) were not actually “clients” of the VC’s adviser (our emphasis below):
For purposes of determining the number of clients of an investment adviser under [the private adviser exemption], no shareholder, partner, or beneficial owner of a business development company…shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner.
But the act went out of its way to say that this definition only applied to VC funds, not all private funds.
Finally in 1985, the SEC “resolved this ambiguity” according to Krug, by treating fund managers as issuers of securities and investors simply as passive investors in those securities, not as clients of the adviser’s advisory services (our emphasis below):
…the Advisers Act…specified that an adviser to a limited partnership may count the partnership, rather than each of its partners, as a client for purposes of the private adviser exemption. Conversely, the rule also specified that a limited partner would not be counted as a client of the partnership’s general partner (or other adviser to the partnership) if the partnership’s interests were “securities” (a condition that is usually met), the advice the adviser provided to the partnership was “based on the investment objectives of the limited partners as a group,” and the adviser was not the “alter ego” of a registered investment adviser.
So it’s no surprise that in its decision on the Goldstein case, the courts said:
Persons engaged in the investment advisory profession “provide personalized advice attuned to a client’s concerns.” Lowe, 472 U.S. at 208. “Fiduciary, person-to-person relationships” were “characteristic” of the “investment adviser-client relationship.” The Court thought it “significant” that the Advisers Act “repeatedly” referred to “clients,” which signified to the Court “the kind of fiduciary relationship the Act was designed to regulate.” This type of direct relationship exists between the adviser and the fund, but not between the adviser and the investors in the fund. The adviser is concerned with the fund’s performance, not with each investor’s financial condition.
After all, said the court, it could even be a conflict of interest if an adviser tried to serve two masters, the fund and its individual investors, at the same time:
If the investors are owed a fiduciary duty and the entity is also owed a fiduciary duty, then the adviser will inevitably face conflicts of interest. Consider an investment adviser to a hedge fund that is about to go bankrupt. His advice to the fund will likely include any and all measures to remain solvent. His advice to an investor in the fund, however, would likely be to sell.
Although it may seem obvious, the SEC felt obliged after its Goldstein loss to emphasize how advisers owed investors at least a duty not to be fraudulent. Many commentators (including us!) ridiculed this measure. But as Krug points out, the gray area was created when the court rejected the fiduciary responsibility between adviser and end-investor compelled such a measure.
Krug is highly skeptical of the common practice where advisers set up and market their own funds. If the fund is both a product of the adviser and the client of the adviser, then any fiduciary duty is essentially owed by the adviser to itself – an “anomaly” she describes as “near absurdity.” However, note that mutual funds, although required to register anyway, have already developed several mechanisms to mitigate this concern such as independent fund oversight.
She also appears to have a dim view of the business practices of hedge funds in general. Krug paints a damning picture of hedge funds that charge management fees less frequently that they allow withdrawals, meaning that “the adviser is compensated for services that it ultimately will not provide.”
She points out that while investment advisers are barred from using third party’s to find clients, they can still use third party marketers to find investors in funds. After losing the Goldman case, the SEC threw in the towel and explicitly acknowledged the role of third parties in raising assets for funds – since those funds were securities and not merely extensions of the adviser’s advisory business. This, writes Krug, exempted marketers from disclosures such as how much they got paid.
In its Goldstein defense, the SEC argued that the distinction between a hedge fund and a hedge fund adviser was “merely a legal artifice” and that advisers don’t have to balance the needs of “two masters” at all. Krug basically agrees and argues that the court should have just defined exclusively the end investor as the client of the adviser. Furthermore, comparisons to other professionals like lawyers or accountants, who would face clear conflicts if they represented both a client and a group to which that client belonged, are inappropriate:
“Goldstein’s use of lawyers and accountants in its analogy is not entirely apt, given the nature of investment advisory services at the time of and subsequent to the enactment of the Advisers Act. Investment advisers, particularly those managing funds, often do not provide the type of complete analyses of their clients’ financial needs that, for example, financial planners might. Rather, many investment advisers simply develop and deploy particular investment strategies. Because of that, they attract clients not through promising to look after all facets of their clients’ financial circumstances but, rather, through the strategies they pursue and the returns those strategies have generated.”
In other words, according to Krug, an adviser might not have a fiduciary duty to advise on all aspects of a client’s financial situation, but that does not preclude them from a fiduciary duty with regard to the specific investment strategy.
In general, providers of professional services aim to satisfy and impress clients - the very hope of further business motivates them to do so. But, as Krug points out, there are certain situations where this motivation may fall short, e.g. when a relationship is long-term in nature, where information is asymmetric, where the services are not entirely transparent, where the interests of the service provider run a chance of diverging from those of the client or when the service provider has a unique skill the client lacks. In these cases, she writes, a “default” fiduciary duty is appropriate, even when there is no directly relationship between the fiduciary and the client:
[F]iduciaries need not have any direct relationship with the principals they serve. Case in point are corporate directors, who owe their duties to the corporation on behalf of shareholders in their capacities as residual claimants, and trustees, who owe their duties to the trust’s beneficiaries, even though the shareholders have no direct contractual relationship with the directors, and the trust beneficiaries need not have any direct contractual relationship with the trustee.
But wait: There is reason to hope that we may finally have some clarity. Krug writes that Dodd-Frank would allow the SEC to define “client” any way it chooses. Alas, she laments, with its goal of forcing hedge funds to register achieved, Krug feels “it is more than conceivable that the SEC, if granted that authority, might decline to use it…”
And so the SEC would have effectively kicked the can down the road once again.